Motivating green innovation through ESG performance shares and ESG-contingent income tax rates

Abstract

We develop a novel multitasking framework in which an agent alters the means, variances and correlations of normally-distributed variables in response to linear and nonlinear incentives. Using this model, we study how contractual and regulatory incentives shape financial and ESG activities. Most notably, we show that ESG performance shares – which apply stronger financial incentives for better ESG performance – incentivize managers to 1) engage in green innovation, increasing the correlation between financial and ESG outcomes, 2) amplify risk in green firms and reduce risk in brown firms, 3) strengthen average financial and ESG performance, and 4) improve measurement quality, increasing the correlation between outcomes and their measures. Moreover, ESG-contingent income tax rates – which apply lower income tax rates for better ESG performance – motivate firms to offer managers ESG performance shares, thereby inducing these activities across all taxable corporations.

Keywords: ESG, CSR, shareholder welfare, taxes, optimal contracting, executive compensation, performance shares, nonlinear contracts, green innovation

JEL Classification: D86, O31, H23